* Money market squeeze, ECB shift fuel dollar surge
* Dollar index up 3.85 pct on week.
* ECB poised to join other major c.banks in cutting rates
* Yen surges as market players unwind stale carry trades
By Eric Burroughs
TOKYO, Oct 3 (Reuters) - The dollar hovered near a one-year peak against a basket of major currencies on Friday as banks and financial institutions have scrambled to buy the U.S. currency after being locked out of frozen money markets.
The dollar held gains scored versus the euro the previous day after European Central Bank President Jean-Claude Trichet said inflation risks have eased, bolstering expectations the ECB will follow other major central banks in cutting rates. [ID:nL2205423]
So far on the week, the dollar has soared 3.85 percent against the basket of six major currencies, its biggest weekly rise in 16 years.
Traders and analysts said the severe squeeze in interbank
lending -- which has driven three-month dollar LIBOR rates
"It's all about fear, the next shoe to drop, and it looks like it's going to be in Europe," said a senior currency trader at a U.S. investment bank in Hong Kong. "Europeans are paying a dear price to fund themselves in dollars, and that's behind the dollar's rise."
The trader said that if money market conditions do not begin to thaw after the expected passage of the $700 billion bank bailout plan in the U.S. House of Representatives on Friday, then market players will look for coordinated central bank rate cuts.
The crisis of confidence among banks after the demise of Lehman Brothers and troubles at other major financial firms has caused interbank lending to all but dry up, leaving many players desperate for dollar funding wherever they can get it.
"There is the added element of dollar buying, regardless of the level, by people facing funding strains," said a senior trader for a major Japanese trading house.
Societe Generale's FX sales desk told clients that "the underlying market theme is the dollar funding story."
The euro rose around 0.3 percent from late U.S. trade to
$1.3862
The single currency rose 0.3 percent to 146.00 yen
The dollar index, which gauges its performance against a basket of six major currencies, dropped 0.3 percent to 80.244 <.DXY> after reaching a one-year peak of 80.794 the previous day.
Trichet and other officials rejected any need for a European rescue fund for banks suffering from the credit crisis as French President Nicolas Sarkozy prepared to host a summit on the crisis in Paris. [ID:nL2522095]
A slew of economic data this week showing the U.S. economy has likely fallen into a full-blown recession has done little to take the wind out of the dollar's rise, even as the Fed is seen likely to cut rates as well this month.
While the dollar has powered higher, so has the yen as the crisis has prompted market players to still unwind stale positions favouring carry trades -- using the low-yielding Japanese currency to buy higher-yielding currencies.
The euro tumbled to a two-year low against the yen, while the Australian dollar slid near a three-year trough touched the previous day.
The Fed's dollar trade-weighted index against major currencies rose 2 percent in September, but the Bank of Japan's trade-weighted index showed the yen gained 4.4 percent the same month. (Additional reporting by Masayuki Kitano; Editing by Chris Gallagher)